Tag: Shadow Banking

I’ve finally organized the thoughts about banking that poured onto the pages of this blog in January. Unfortunately, the argument does not lend itself to convincing exposition in a blog post. So anybody who’s interested is going to have to trundle over to SSRN and download the paper, Shadow Banking: Why Modern Money Markets are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’. I’ll warn you upfront, it’s tl;dr with a vengeance. On the other hand, I’m a pretty concise writer, so you’ll find I cover an awful lot of ground, if you give me an hour or two of your time.

Some highlights:

I start with Shadow Banking is an Unstable Funding System for Banks, Not Assets (so if you’re already familiar with the blogpost, you can skip that part).

I continue with my interpretation of why the industrial revolution took off in Britain: the banking system, of course — and it’s ability to create money. To make the point, I very briefly explain the nature of early modern financial markets, and how they gave birth to fiat money.

I then explain the components of the system that allowed 19th c. bankers to create risk-free private sector assets. Next I explain how these components fit in with a theoretic model of banking, and distinguish this model from Gorton and Ordonez model of “informationally insensitive” bank debt. (Don’t worry, no math.)

Then I argue that the 19th c. lender of last resort, as it was understood by Bagehot, did not only serve as a source of liquidity, when panics threatened a crisis of confidence in the (fundamentally sound) banking system, but also actively managed moral hazard by explicitly withdrawing support from institutions that were undermining the quality of the money supply.

At last I come back to modern shadow banking, explaining how the modern perversion of the “lender of last resort” into “too big to fail” has led to the growth of extraordinarily unstable forms of funding, including financial commercial paper and repo. Collateralized money markets in particular maximize the value of the central bank put, by draining liquidity when it’s most needed.

I explain why a “dealer of last resort” cannot support asset market prices in general, but can only protect asset markets from forced sales by the specific dealers who are granted access to the central bank.

Finally, I distinguish the tight connection that exists between traditional commercial banking and the real economy from the much more ambiguous relationship between traditional dealer banks and the real economy. After all, traditional dealer banks don’t hold assets on their balance sheets over the long term and are far more focused on their short-run ability to sell off an asset, than in the asset’s performance over the long run.

It is because of the important role that commercial banks play in the real economy that they have privileged access to the lender of last resort facilities of the central bank. Dealer banks don’t play the same role and don’t deserve similar support. As for shadow banking, repo markets, to the degree that they fund private sector assets at all, fund market-traded assets and don’t support unsecured lending to smaller businesses, whereas asset backed commercial paper markets are steadily shrinking now that avenues of regulatory arbitrage are being closed.

There are many definitions of shadow banking. A New York Federal Reserve Bank monograph effectively equates shadow banking to securitization, or the process by which individual loans are packaged into bundles, used to issue a wide variety of collateralized assets, and sold to investors. The New York Fed monograph is often used to demonstrate how complicated and virtually incomprehensible the shadow banking system is – it includes a “map” of the shadow banking system that, for legibility, the authors recommend printing as a 36” by 48” poster.[1]

More commonly, however, the term shadow banking refers to the use of money market instruments to provide short-term finance to long-term assets,[2] and thus focuses attention on bank runs and on the fact that shadow banks can face such runs, just as traditional banks do. For this reason securitization should not be equated with shadow banking, because a significant portion of private sector securitized assets were financed on a long-term rather than on a short-term basis.[3] This post will limit its focus – as does most of the literature on shadow banking – to the role played by money markets in longer-term finance.

This post finds that our current money markets play only a very small role in the direct finance of private sector long-term assets and for the most part are used as a financing system for investment banks. In short, the “market-based” credit system that some equate with the shadow banking system,[4] is very small – and relies heavily on commercial bank guarantees. To the degree that a substantial shadow banking system continues to exist, it does not fund long-term assets directly, but instead provides wholesale funding for investment banks, and to a lesser degree commercial banks.

To be clear, the focus here is on finance of private sector banks and assets. Thus, although Fannie Mae and Freddie Mac played a very important historical role in the development of the shadow banking system, by pioneering the practice of financing long-term mortgage debt on money markets through the issue and roll over of short-term debt that was at least nominally a private-sector obligation,[5] they now officially have government support, and, for the purposes of this paper their debt is treated not as part of the shadow banking system, but as a government obligation.

This post provides a simple framework for understanding the shadow banking system that is organized around the two instruments, commercial paper and repurchase agreements, that play an important role in money markets and that are, very roughly, comparable to deposits. Studying how these instruments are used not only allows a distinction to be drawn between the direct finance of assets and the finance of assets that sit on bank balance sheets, but also makes clear why the shadow banking system is unstable.

This analysis finds that the money market instruments have in the past played three roles: they have funded banks and non-financial firms directly, they have funded assets that lie off bank balance sheets, and in order to play these roles, they have created a need for commercial bank guarantees that induce lenders to lend off-balance-sheet or in the case of tri-party repo to investment banks. In practice, the direct funding of assets now takes place only on a very small scale.

Because the two money market instruments, commercial paper and repurchase agreements (repos), are both short-term, it is easy for those who invest in them to “run,” or to decide that they no longer wish to invest their funds with a specific issuer or, indeed, in privately issued money market assets at all. Because these investors can always choose to put their money in Treasury bills or bank deposits, runs in the money markets are associated with unmanageably sudden shifts in investor preferences across short-term assets. In short, a fundamental attribute of the shadow banking system is that the decisions of money market investors can destabilize the money markets.

Money market mutual funds and enhanced cash funds (that promise liquidity, but are less regulated than money market funds) are the most obvious money market investors, but the buy-side of the money market is composed of a huge array of institutional investment funds, corporations, and government bodies that have funds they wish to keep in liquid form. All of these entities can be part of a run in the shadow banking system. In addition, as will be explained in detail below, in the repo market it is possible for the recipients of funds, such as prime brokerage clients and banks in the interdealer market, to run.

Now that the basic instability of the money markets has been established, the next step in understanding the shadow banking system is to understand the different ways in which commercial paper and repo-based instruments are used; this is discussed in sub-part A. The following sub-parts evaluate what shadow banking does, and discuss why it is more unstable than traditional banking.

A. Shadow Banking Instruments

1. Commercial Paper

a. Unsecured

Commercial paper is traditionally an unsecured obligation to make a payment that has a maturity of one year or less. It is analogous to the commercial bills that were used to finance economic activity in 19th c. Britain, and indeed has existed in one form or another for centuries.

i. Issued by financial institutions

A little over half the commercial paper issued in the United States, or approximately $550 billion, is issued directly by financial institutions.[6] Because this market-based funding source is much less stable as a funding source than retail deposits, it is categorized along with other bank funding sources that are prone to runs as wholesale funding. The case of Lehman Bros. illustrates the instability of this form of funding. When Lehman declared bankruptcy, its commercial paper went into default, and set off a run by investors who feared money market mutual fund losses on money funds that invested in commercial paper; as a result the commercial paper market itself faced a run.

ii. Issued by non-financial corporations

Approximately one quarter of commercial paper is unsecured and issued by non-financial corporations. Because non-financial corporations have less access to liquidity than banks, there is a risk that when their commercial paper is due they will be unable to roll it over into a new issue and will be unable to honor their commercial paper obligations due to this liquidity risk. For this reason, almost all non-financial commercial paper is protected by a liquidity facility provided by a bank, which promises to retire the commercial paper if the issuer is unable to do so. Observe that when Lehman failed, the run on commercial paper was not carefully targeted to financial commercial paper, and as a result non-financial commercial paper was subject to a run as well.

b. Collateralized: Asset Backed Commercial Paper

In recent decades, sponsoring banks have moved assets that they originated into financing vehicles that are “bankruptcy-remote,” or not available to the sponsor’s creditors in the event that the sponsor declares bankruptcy. In addition, in theory any support that would be provided by the sponsor to the vehicle was defined in a contract, so the sponsor had contractually limited exposure to the vehicle’s liabilities.[7] Thus, these vehicles were designed as a means of removing assets from the sponsoring bank’s balance sheet.

The ABCP market was one of the key markets that collapsed in the early days of the financial crisis – from $1.2 trillion outstanding in early August 2007 to $905 billion three months later. Since then the market has continued to decline slowly, and it now hovers around $250 billion.

Because these vehicles finance long-term assets they face the same liquidity risk as non-financial issuers when issuing commercial paper. In addition these vehicles face credit risk in the event that the value of the assets falls below the value of the commercial paper, and the vehicle is no longer fully collateralized. Both liquidity and credit risk must be addressed before the vehicle can receive a credit rating that is high enough for it to issue asset-backed commercial paper (ABCP) that is secured by the assets in the vehicle. The three principal means by which liquidity and credit risk were resolved are discussed below.

i. Bank supported ABCP: Conduits

Prior to the financial crisis most ABCP was issued by ABCP conduits that were sponsored by banks. The banks typically provided both a liquidity facility, which guaranteed that the commercial paper would be retired even if it could not be rolled over, and a credit facility, which promised to honor some fraction of the commercial paper in the event that the value of the collateral fell too low to cover the costs of repaying the commercial paper.

In August 2007 when the crisis started there was a sudden loss in confidence in the ABCP market and many conduits could not roll over their commercial paper. The banks had to step in and honor the liquidity guarantees that had been made – and in order to do so they had to seek regulatory exemptions that are documented by the Federal Reserve.[8]

ii. Liability structure supported ABCP: SIVs, LPFCs, etc.

Some ABCP-issuing vehicles guaranteed the payment of ABCP by funding the assets with a combination of bonds, medium-term notes and ABCP. These vehicles took many forms; the most common were called structured investment vehicles (SIVs).

The concept behind these vehicles was that, in the event that the commercial paper could not be rolled over or the value of the assets fell below a trigger point, assets would have to be sold to pay off the ABCP and any losses would fall to the longer term debt holders. In 2007 most SIVs hit their triggers and were unwound. Because of the losses that were incurred by both longer-term and commercial paper investors (after lawsuits determined the allocation of proceeds), they are no longer a popular investment product.

iii. Repo Conduits – discussed below

2. Repurchase Agreements

A repurchase agreement (repo) is a simultaneous agreement to sell an asset today and to repurchase it a specific date and time in the future. It has the same economic effect as a collateralized loan. Typically the amount lent is less than the value of the collateral;[9] the percentage difference is called a haircut.

There are two repo markets: the bilateral repo market and the tri-party repo market. In the bilateral repo market the lender must have the capacity to receive and manage the collateral, whereas in the tri-party repo market the tri-party clearing banks, JP Morgan Chase and Bank of New York Mellon, provide collateral management services for the lenders. Money market investors like mutual funds lend only on the tri-party repo market where the principal borrowers are the dealer banks (although a few hedge funds and private institutions are credit-worthy enough to be accepted as counterparties on this market).[10]

The clearing banks also provide bank guarantees of liquidity to the tri-party repo market. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day giving the borrowers access to their assets during the day, the two tri-party clearing banks extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[11] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[12]

On the bilateral market, where the lender must manage the collateral, the dealer banks are the lenders. The borrowers are prime brokerage clients, such as hedge funds, and other dealers.

As a result of this structure, funding generally enters the repo market via tri-party repo and the dealer banks, then, distribute this funding more broadly to their prime brokerage clients on the bilateral repo market. Thus, when a hedge fund buys an asset on margin, it borrows a significant fraction of the purchase price from the dealer bank that is its broker and posts the asset as collateral for the loan in a repo transaction. The dealer bank can then repo the asset on the tri-party repo market so that the dealer bank is effectively intermediating lending from the tri-party market to its client and earning an interest rate spread for the intermediation services. When the asset is of a type that cannot be used as collateral in the tri-party repo market, the dealer may choose to use the asset to raise funds on the inter-dealer segment of the bilateral repo market.

The dealer banks also hold collateral that is posted against derivatives contracts by other dealers and by prime brokerage clients. Whereas the inter-dealer derivatives contracts may have symmetrical collateral posting requirements, prime brokerage clients have typically been required to post collateral without having the right to require that dealer bank follow the same rule when the balance on the derivatives contracts is in the brokerage client’s favor. As a result a dealer bank is almost certain to receive collateral from its prime brokerage services when its client accounts are aggregated. The collateral posted by prime brokerage clients can then be used by the dealer to borrow in the tri-party repo market. As a result of this structure collateral posting by prime brokerage clients on their derivatives liabilities is also a form of financing for the dealer banks.

Thus, dealers often finance their own inventories, their prime brokerage clients’ assets, and any collateral that is posted against derivatives liabilities by other dealers or prime brokerage clients on the tri-party repo market.

The repo market is very different from the ABCP market and from commercial paper markets in general, because a run in one of the latter markets can only be caused by end investors. In the repo market a run can be started either by end investors or by other dealers and/or prime brokerage clients. Darrell Duffie has explained the many channels by which funding can be withdrawn in a repo market. These include: brokerage clients can move their accounts – together with all the collateral they have posted – to another dealer; dealers or brokerage clients who are derivatives counterparties can seek a novation (i.e. transfer) of a derivatives contract in order to post collateral to or expect payment from a more creditworthy dealer; dealers or brokerage clients may seek to reduce new exposures by entering into derivatives contracts that will require a dealer to post collateral; or repo lenders may increase haircuts or stop lending entirely to the dealer.[13] In short, the repo market is subject to inter-dealer and brokerage client runs, as well as to runs by repo investors.

In 2008 it is very clear that both Bear Stearns and Lehman faced a withdrawal of funding from other dealers, from brokerage clients, and from end investors in the repo market.[14]

3. Repo Conduits

A repo conduit is a bankruptcy remote financing vehicle. The vehicle issues commercial paper that is backed by a repo with a maturity that matches the commercial paper. Thus, a repo conduit is backed primarily by the credit of the repo counterparty. Only if the repo counterparty fails to pay, can the repo conduit foreclose on the repo collateral. Because the term of the repo matches the term of the commercial paper, rating agencies do not require that a repo conduit have a backup liquidity facility.

The credit rating of a repo conduit typically is based entirely on the credit of the repo counterparty.[15] For this reason, repo conduits can be used – by institutions with high credit ratings – to finance assets that would not be eligible for tri-party repo financing.

B. What Does Shadow Banking Do?

1. Shadow Banking is a Funding Mechanism for Banks

The most important role of the shadow banking system is to provide wholesale funding for banks. Unsecured wholesale funding is provided when a bank issues commercial paper. Secured wholesale funding is provided when a investment bank uses the tri-party repo market to finance inventories, the assets of brokerage clients, and any collateral posted by counterparties in derivatives transactions.

As of Dec. 31, 2013, financial institutions raised $550 billion unsecured on financial commercial paper markets and the dealer banks used the tri-party repo market to borrow on a secured basis close to $1.6 trillion. 80% of the collateral posted is Treasuries and Agencies. Only $330 billion of private sector assets are financed on this market.

2. Shadow Banking is a Funding Mechanism for Assets

Before the crisis, the shadow banking system played an important role in funding assets with liabilities that were secured by assets that were held off of bank balance sheets in bankruptcy remote vehicles. When this secured asset funding relied on bank support, it was usually provided by ABCP conduits. When this secured asset funding was made possible by a tiered liability structure, it was provided by SIVs and similar vehicles. When this secured asset funding relied on a maturity-matched repo, it was provided by a repo conduit.

Before the crisis the ABCP market was the most important source of shadow bank funding of private sector assets. (Not only did the tri-party repo market fund private sector assets that were for the most part on dealer bank balance sheets, but it was dominated by Treasuries and Agencies and thus played a relatively small role in financing private sector assets even indirectly.[16]) In post-crisis markets vehicles like ABCP and repo conduits are financing far fewer assets than they did before the crisis. The ABCP market is continuing its slow but steady decline over time and now hovers in volume around $250 billion.

When assets were directly financed by the shadow banking system, it was usually because financing vehicles paid a small fee to “rent” a commercial bank’s credit rating by purchasing a guarantee of the vehicle’s liabilities. Because these guarantees were off-balance sheet, the bank was able to avoid the capital requirements that would have been imposed if the bank had done the lending itself. The role played by the clearing banks in the tri-party repo market is similar: they provide intraday credit in order to give dealer banks access to their assets during the day, but face no capital charge for the credit. Thus, a key function played by shadow banking is the arbitrage of capital regulations.[17]

The liquidity and credit facilities provided by banks to ABCP conduits are examples of unsecured bank guarantees.[18] By contrast, the tri-party clearing banks provide secured guarantees. The intra-day credit that the clearing banks provide to the dealer banks is secured by the collateral that has been posted on the tri-party repo market. Banks may also issue guarantees in the form of swaps that offset the market risk of collateral; these guarantees may be secured or unsecured depending on the derivative contract.

The collapse of the ABCP market since regulators have become attuned to the problem of regulatory arbitrage of capital requirements is just another piece of evidence that the vast majority of financing on the ABCP market at its peak was not driven by economic efficiencies, but by regulatory arbitrage as banks used liquidity and credit facilities to take on credit risk, while avoiding capital requirements. Indeed, the industry reaction to the 2004 Final Regulation governing such liquidity facilities – which resulted in a “reinterpretation” of the regulation that effectively gutted it – is also evidence of the importance of regulatory arbitrage to this market.[19]

C. Collateralized Money Markets Are More Unstable Than Traditional Banks

The use of collateral in repo markets makes them particularly unstable for two reasons: leverage and the fact that not just lenders, but borrowers, can start a run.

When the price of the collateral in a repo contract falls, the borrower is typically required to post more collateral within a day, and, in the event that the collateral call is not met, the collateral that was posted can be liquidated immediately. While this description shows how quickly market price changes can be reflected in the sale of collateral on repo markets, it does not take the leverage that is ubiquitous on repo markets into account. Because of leverage small changes in the market price of an assets can force the borrower to sell off a large fraction of the borrower’s holding of that asset.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[20] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

Not only does leverage make repo markets inherently unstable, but, in addition, a key characteristic distinguishing the repo market from unsecured credit markets generally is that not only the lenders, but also the borrowers, can start a run. The use of collateral in bilateral repo markets makes a borrower run possible, because the collateral can be rehypothecated, or posted as collateral in a subsequent loan by the recipient of the collateral. In short, the collateral posted by borrowers in the bilateral repo market is a source of liquidity for the lender.

When borrowers decide that they don’t want to be exposed to a troubled lender that may not be able to return the borrowers’ collateral in the event that it fails, the borrowers may seek to transfer their accounts to a lender who is not troubled. When the borrowers’ accounts are transferred, the collateral they have posted it transferred with the accounts, and the troubled lender loses the liquidity that was provided by that collateral.

As a result of this property of the repo market, the dealer bank failures of 2008 were characterized by “runs” by both prime brokerage clients and other dealers, none of whom wanted to be exposed to a failing bank. In fact, Krishnamurthy, Nagel, & Orlov conclude that the evidence supports the view that the 2008 crisis looks more like an inter-dealer credit crunch than a run by end investors on the two firms.[21] For these authors one factor distinguishing the two types of runs is the fact that the dealers are well-informed market participants, whereas end investors typically must decide whether to pull out of the market based on very limited information.[22] In short, it is possible that, far from being comparable to bank runs, the runs that took place in 2008 were runs that started with the most informed participants in financial markets.

Thus, there are two very important differences that make the repo market more unstable than unsecured funding markets. Not only does leverage mean that a small decline in price can easily force a large sale of asste, but in the bilateral repo market a run can be started not only by lenders, but also by borrowers.

In conclusion, it is misleading to describe the shadow banking system that exists today as “money market funding of capital market lending” and to focus on it as a means of financing assets,[23] because at present by far the most important use of shadow banking instruments is to provide wholesale funding for dealer banks and through them indirect financing of assets that sit on their balance sheets. Although the view that shadow banking finances assets directly may have held some truth prior to the crisis when $1.2 trillion of ABCP financed bankruptcy remote vehicles, today, to the degree that shadow banking disintermediates commercial banks, it does so by reintermediating investment banks – using a form of funding that is even more unstable than deposits.

The key question that regulators have yet to answer is whether this collateralized wholesale funding market is a valuable addition to the financial system or whether the risk of instability that accompanies it is so great that lending on this wholesale market should be curtailed.

[9] Note that in securities lending, where institutional investors provide high-quality, high-demand collateral like Treasuries to the market, haircuts frequently go in the reverse direction. That is, more money must be lent than the value of the collateral in order to induce the securities lenders to lend.

[12] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[13] Darrell Duffie, How Big Banks Fail 23 – 42 (2011). See also William Dudley, More Lessons From the Crisis, Remarks at the Ctr. for Econ. Policy Studies Symposium, (Nov. 13, 2009), available athttp://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html; Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market before the 2010 Reforms 56-58 (Fed. Res. Bank of N.Y. Staff Rep. No. 477, 2010).
Duffie observes that when there is a repo market run, the coup de grace is almost always given by a clearing bank when it responds to concerns about a firm’s financial position by exercising its right to offset aggressively, by for example demanding collateral for intraday exposures or refusing to give access to deposits. Duffie, supra note 9, at 41¬-42. See also Tobias Adrian & Adam Ashcraft, Shadow Banking Regulation 17 (Fed. Res. Bank of N.Y. Staff Report No. 559, 2012).

[17] Carolyn Sissoko, Note, Is financial regulation structurally biased to favor deregulation, 86 Southern California Law Review 365 (2013). Sissoko also has a discussion of the broader literature on the role of regulatory arbitrage in the ABCP market.

IV. Should the Collateralized Money Market be Stabilized or Euthanized?

This is Part IV of a lengthy critique of Bagehot was a Shadow Banker by Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson. The authors of Bagehot was a Shadow Banker equate the shadow banking system with what they call the “market-based credit system” (at 2). To be clear, the authors focus specifically on a market-based short-term credit system or on money markets. In this Part I ask what does it mean to call a credit system “market-based” and whether such a system exists, then I discuss the consequences of moving from an unsecured money market to a collateralized money market, and finally I evaluate the likely effectiveness of the solution proposed by the authors of Bagehot was a Shadow Banker in stabilizing the collateralized money market.

A. Does a “market-based” credit system exist?

The “market-based” credit system is often contrasted with the “bank-based” credit system to distinguish environments where firms raise funds by issuing securities on markets from those where firms raise funds by borrowing from banks.[1] This distinction is clear when we focus on long-term capital markets, such as bond markets where established companies can and do raise money on a regular basis.

When it comes to money markets, however, the line between market-based and bank-based systems cannot be clearly drawn, because the so-called market-based systems rely heavily on guarantees provided by the banking system. The principle instruments used to borrow short-term on markets are commercial paper (the short-term version of a bond) and repurchase agreements, in which the borrower simultaneously sells an asset and agrees to repurchase it at a fixed future date and price, effectively creating a collateralized loan. As was discussed in Part II, as a rule non-financial companies can only borrow on these markets if they have liquidity support from a bank: Because commercial paper typically needs to be rolled over at maturity, almost all non-financial issuers including asset-backed commercial paper conduits must have a liquidity facility, or a bank’s promise to retire the paper if the issuer is unable to do so. Similarly, the most important repo market is backstopped by guarantees provided by the tri-party clearing banks, which bear the credit risk of the borrowers during the day. In short, in the money markets the “market-based” credit system might as well be called the “bank-guaranteed” credit system.

Furthermore, because so-called “market-based” money market instruments require bank guarantees and those guarantees are most likely to be called upon in a crisis, the “market-based credit system” insulates banks from the credit risk of borrowers in normal times, but not in crises. Because such instruments are always designed in normal times when the likelihood that the bank will be obliged to make good on its contingent liability is deemed minimal, these instruments create a form of bank risk that typically carries lower capital requirements than alternatives. For these reasons, the “market-based” short-term credit system is best viewed as a form of bank lending that is designed to minimize capital requirements, and it should be categorized as lying within the “bank-based” credit system.

Another sense in which money market instruments are only nominally “market-based” is that these assets do not trade on secondary markets. Commercial paper is placed and almost never resold before maturity. Repo obligations, similarly, are not traded actively, but held until maturity.[2] By contrast, in 19th c. London, the archetype of a traditional bank-based credit system, there was an active secondary market in the bills that were the primary tool by which central bank policy was implemented.

Repurchase agreements and asset-backed commercial paper (but not commercial paper more generally or 19th c. bills) are both collateralized forms of “market-based” money market instruments. Such collateralized money market instruments can also be considered “market-based” in the sense that they are subject to market risk; that is, if the value of the collateral falls below the value of the debt, the borrower will have to post additional collateral. Market risk is a key concern of the authors of Bagehot was a Shadow Banker, and it is possible that when the authors use the term “market-based credit system” they mean only to refer to collateralized money market instruments that are subject to market risk; if this is the case, in my view, the term, collateralized money market is more clear.

It is not clear whether the authors of Bagehot was a Shadow Banker imagine a world in which so-called “market-based” money market instruments exist without the support of bank guarantees. If so, it should be noted that their solution is tailored to market risk, whereas the bank guarantees are needed to address funding risk. That is, even if there were no market risk and the collateral’s value could not fall, the possibility that the borrower would find itself illiquid and unable to retire or to roll over the debt (for reasons specific to the borrower or to the money market, not to the collateral) would almost certainly mean that funding guarantees were still necessary to support the market.

To summarize, because the finance of longer-term assets requires that these short-term instruments be rolled over, funding risk is always a concern in the so-called “market-based” short-term credit system, and this almost certainly means that this “market-based” credit system cannot exist except when it is backstopped by the banking system. Thus, what is commonly known as the “market based” short-term credit system – including most of the shadow banking system – should properly be understood to lie within the “bank-based” credit system.

The rest of this Part will assume that the authors use the term “market-based” credit system only for the purpose of focusing attention on the market risk inherent in the collateralized portions of the money market. Thus, I will focus on what I will call the collateralized money market.

B. Is transforming credit risk into market risk a good idea?

In the collateralized money market, borrowing is collateralized in order to provide additional security to the lender, and market risk substitutes for a portion of the credit risk that lenders traditionally face. From the borrowers’ point of view less-creditworthy borrowers have access to credit, but this access comes at the expense of raising the costs of borrowing for borrowers, who now have to worry not only about having the resources to pay the debt at maturity, but also about maintaining sufficient collateral to back the loan throughout the life of the loan. Thus, borrowers will elect to use this system if they are not sufficiently creditworthy to borrow unsecured or they have easy access to collateral.

The authors of Bagehot was a Shadow Banker are correct to emphasize that the most important difference between 19th c. British money markets and modern money markets is the role that market risk plays in modern markets. 19th c. money markets focused on managing credit risk exclusively – so much so that Thornton viewed the “science” of credit as the great innovation of the British banking system and a driving force of the economy’s growth.[3] The careful management of credit risk in the 19th c. is illustrated both by the fact that every bill discounted by the Bank of England was guaranteed to be paid in full by at least three different parties, the issuer, the acceptor, and the discounter, and by the fact that the Bank had negligible losses on its discount portfolio, even after a crisis.[4]

The authors of Bagehot was a Shadow Banker treat the growth of market risk and collateralized money market assets as a demand-side phenomenon (at 12). They reference Pozsar’s work which emphasizes that the largest lenders in modern markets, asset managers such as mutual and pension funds, are reluctant to extend unsecured credit to the banks in the form of uninsured deposits and prefer to lend via repos or asset backed commercial paper.[5] (Note that this point should not be overemphasized, because banks are able to raise significant funds, unsecured, by issuing commercial paper.) The second demand-side explanation for the growth of the collateralized money market is the modern asset management practice of using derivatives markets to take on the risks of investing while holding invested funds in monetary assets. Presumably, supply-side effects may also have played a role in the growth of this market, as investment banks found the market both convenient for financing inventories, and possessed of the useful property that in normal times the market was not very sensitive to changes in the credit quality of the borrower.[6]

The authors view this transformation of the money market from one in which credit risk was carefully managed to one where market risk substitutes for credit risk as a benign, if not beneficial, development. There are, however, many concerns that this development should raise.

First are the implications the movement towards collateralized short-term lending may have for the credit quality of our financial institutions. It is possible that this movement reflects declining credit quality among financial institutions that makes it difficult for them to borrow on an unsecured basis. The fact that this change took place alongside the transformation of the investment banking industry from unlimited liability partnerships to limited liability corporations may be an indicator that declining credit quality is an important driving force behind this change. Another potential concern is that the movement to collateralized short-term lending aggravates declining credit quality among financial institutions. Research has shown that repo lending terms are principally determined by the quality of the collateral posted and do not tend to reflect incremental changes in the credit quality of the borrower.[7] For this reason, it is possible that the movement towards collateralized borrowing makes borrowers less concerned about whether or not they are viewed as good quality borrowers.

Second, as was discussed in Part I, early monetary theorists such as Henry Thornton believed that banking contributed to economic growth because it allowed the money supply to expand based on the needs of the economy and that the “science” of credit facilitated this expansion. Collateralized money markets, however, substitute market risk for credit risk, and as techniques for issuing unsecured money market instruments fall into disuse may have the effect of limiting the use of unsecured credit more than the principles of managing credit risk would require. If unsecured credit falls into disuse, the growth of the money supply, and arguably of the economy itself, may be limited by a deficit of collateral. In short, it is not clear that collateralized money market instruments can play the same role in expanding the money supply and in economic growth as that played by unsecured money market instruments.

Finally, repo markets are likely to be even less stable sources of funding for financial institutions than deposits, and thus even more prone to fire sales. Because the realization of market risk in collateralized lending markets can force immediate deleveraging, the availability of funding on repo markets can disappear just as quickly as deposits can be withdrawn – and even more quickly than credit based on unsecured term instruments which can only be withdrawn as the instruments mature. In addition, however, the fact that the collateral on repo markets is funded on a leveraged basis means that small changes in the market prices of assets can result in the need to sell off a large fraction of assets. Because of leverage, repo markets are probably less stable than deposit-based funding.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[8] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

C. Should collateralized money markets be stabilized by protecting leveraged dealers from losses?

The authors of Bagehot was a Shadow Banker recognize that collateralized money market instruments are prone to fire sales and liquidity spirals, but they do not appear to realize that, due to the leverage that is used in repo markets, very small price declines can have very large effects. They argue that a dealer of last resort is all that is needed to stabilize these markets, and that the dealer can do this by putting a price floor on the assets used as collateral. Specifically they write:

just as in Bagehot’s day, the critical infrastructure is an interconnected system of dealers, backstopped by a central bank. Just as in Bagehot’s day, the required backstop may involve commitment to outright purchase of some well‐defined set of prime securities (such as Treasury securities). But it must also involve commitment to accept as collateral a significantly larger set of securities, in order indirectly to put a floor on their price in times of crisis. (at 9).

Two points should be emphasized with respect to this proposal. First, it is important to understand that despite the authors’ focus on the support of asset prices, the key innovation in the “dealer of last resort” proposal is the extension of central bank support to dealers. Secondly, because dealers are very different from banks, the extent of the support provided by the central bank to dealers is likely to be much greater than that provided to banks.

As for the first point, the Federal Reserve has had the ability to accept virtually any security as collateral since 1932 – as long as it was collateral for a loan to a commercial bank.[9] The problem in 2008 was not the nature of the collateral that could be used, but the fact that investment banks didn’t have access to the central bank. Thus, the key innovation of the “dealer of last resort” proposal is not the type of collateral that can be used for a loan, but the fact that dealers – or investment banks – are able to borrow from the central bank using that collateral.

For non-prime assets, the proposal is only that the central bank accept them as collateral, not that it buys them outright. One potential advantage of accepting assets as collateral, rather than buying them outright, is that the central bank may not need to determine their value, but can choose to rely on the valuation of the collateral given by the borrower, because the borrower will be liable for any shortfalls if the collateral is worth less than the loan. In this case, the purpose of accepting an asset as collateral is not to “put a floor” on its price, but to prevent the borrower from being forced to sell it in a fire sale. This is an important distinction to make, because the central bank is not, in fact, intervening in the market pricing mechanism in the way that the phrase “put a floor on the price” implies. Instead, the central bank is making it possible for the borrower to carry the asset at the valuation at which the borrower is willing to buy the asset back in the future. The level of the asset’s market price is affected, but not determined, by this policy.

Under this interpretation of the proposal, the dealer of last resort should not be viewed as supporting the price of assets (as the authors claim in many places), but as supporting the dealer system. While this understanding is not consistent with “putting a floor” on asset prices, it is more consistent with the author’s claim that when the central bank intervenes, the price decline “is not so much halted or reversed as it is contained and allowed to proceed in a more orderly fashion” (at 14). After all, if the goal is to put a floor on the price of the assets, it doesn’t make much sense to claim that these prices will continue to decline in an “orderly fashion.”

Secondly, the function of dealers in supporting market liquidity is very different from the function of banks in honoring deposits and funding guarantees; as a result the nature of a central bank backstop, and indeed the degree of reliance on the central bank is likely to be very different for a dealer of last resort as compared to a lender of last resort. In order to address the problem of liquidity spirals, the authors of Bagehot was a Shadow Banker argue that:

what is clearly needed is some entity that is willing and able to use its own balance sheet to provide the necessary funding. … what we need is a dealer system that offers market liquidity by offering to buy whatever the market is selling. Only in crisis time does the central bank backstop become the market; in normal times, the central bank backstop merely operates to support the market. (at 9).

Because the primary work of a dealer is that of smoothing the market’s movement to a new price, and not of setting a floor on asset prices, it’s far from clear that dealers can ever be expected to the play the role that the authors of Bagehot was a Shadow Banker seem to expect them to play in supporting prices on markets. The traditional constraints on the behavior of a dealer are described by Jack Treynor, the source of the authors’ model of dealer pricing: “the dealer has very limited capital with which to absorb an adverse move in the value of the asset. Furthermore, the dealer’s spread is too modest to compensate him for getting bagged.”[10] Treynor contrasts the role played by a dealer with that of an investor who has the capital to hold positions over a longer term. Thus, a traditional dealer does not “use its own balance sheet to provide the necessary funding” except over very short time horizons. On the other hand, it is true that large-scale proprietary trading and the management of balance sheet exposure to related risks has become a core function of dealers in recent decades. (This is almost certainly related to the role played in the market by limited liability investment banks that have access to vast capital resources the use of which is monitored, not necessarily effectively, by boards of directors.)

Because the traditional function of a dealer is not to support asset prices, however, it seems likely that even dealers engaged in large-scale proprietary trading will let a liquidity spiral run before stepping in to buy in significant quantities – and then they may well allow the price to continue falling as they build up a significant stake in the assets. After all, if sellers want to sell at unreasonably low prices, this will only add to the dealers’ proprietary trading profits in the end.

Indeed, this is what we witnessed in 2008 when Bear Stearns and Lehman were failing: for the most part, the dealers instead of using their balance sheets to support prices on the market sought to avoid being caught holding assets that are falling in value. Thus, one would expect the burden of establishing a price floor for assets to fall heavily on the dealer of last resort or central bank, just as it fell heavily on the Federal Reserve which had to jerry rig facilities such as the Primary Dealer Credit Facility and the Term Securities Lending Facility in order to take on hundreds of billions of dollars of the asset risk of the investment banks in 2008.[11] At the start of October 2008, these two facilities accounted for 60% of the massive expansion of the Federal Reserve’s balance sheet as compared to the previous year. In short, because providing a price floor for assets is not the economic function of a dealer, a central bank that acts as a “dealer” of last resort must be prepared to purchase assets on this scale – and effectively to become the market – in every crisis.

These two points indicate that the value of the dealer of last resort policy is that a troubled dealer can use the assets as collateral to borrow from the central bank, and doesn’t need to sell them at all. The fact that the largest market participants are protected from ever finding themselves forced to sell their assets will undoubtedly be very effective in protecting asset prices from instability due to massive fire sales.

But the proposed policy would also introduces a very troubling asymmetry into our markets. Who has access to central bank’s discount window? Retail investors clearly do not, whereas “dealers,” however they end up being defined, do. The privileged dealers effectively have access to an unlimited balance sheet and can employ leverage without worrying about being forced into a fire sale – and no longer face the traditional constraints that govern dealers’ activities.[12] By contrast, those without this privilege are limited by their capital position in the degree to which they can increase their profits using leverage.[13]

In short, this policy is likely to have the effect of protecting the privileged dealers from losses due to market risk, while other market participants do not receive similar protection. By reducing the costs of leverage to the privileged dealers it is also likely to increase their use of leverage. If the central bank does not monitor the behavior of the privileged dealers vigilantly, it could end up making financial markets more risky, by making the largest financial market participants believe that it is “safe” for them to take on more risk.

These dangers are offset in part by the fact that the dealer of last resort’s actions in a crisis will forestall an immediate collapse and the economic repercussions of such a collapse. And this fact almost certainly justifies the Federal Reserve’s actions in 2008. It is less clear that this fact is enough to justify embracing the “dealer of last resort” proposal as a standing policy.

The reason that the lender of last resort is good policy, whereas the dealer of last resort probably is not good policy, is that banks are different. Their value lies in making possible money markets based on unsecured credit that is extended broadly across the business community and makes modern economic growth possible. The banking system merits the protection of a lender of last resort, because it provides such broad benefits to the community at large, and there is good reason to believe that without a lender of last resort a banking system will collapse entirely.

There is, by contrast, a long history of dealer systems that support trade on financial markets and are not at risk of collapse in the absence of a dealer of last resort. Furthermore, there is little or no evidence that collateralized money market instruments play the same role as uncollateralized money market instruments in economic growth, and thus little or no evidence that collateralized money markets are necessary to the community at large. In fact, the growth of collateralized money markets may undermine traditional unsecured money markets, where a financial institution’s ability to borrow depends on its credit quality, and thereby undermine the market forces that promote high credit quality in the financial industry. For this reason, the collateralized money markets may be destabilizing the financial industry. While the temporary support of these markets in 2008 was well justified, much more evidence of the value of collateralized money markets to the process of economic growth needs to be presented before dealers and investment banks are given privileges similar to those of commercial banks.

[9] Critics complained that “any cat and dog” could be used as collateral at the Fed, after the Federal Reserve Act was amended in 1932. David McKinley, The Discount Rate and Rediscount Policy 97, quoted in David Small and James Clause, The Scope of Monetary Policy Actions Authorized Under the Federal Reserve Act 10 n.22 (FEDS Research Paper 2004-40, 2004).

This is Part III of a lengthy critique of Bagehot was a Shadow Banker, written by Perry Mehrling, Zoltan Pozsar, James Sweeney and Daniel Neilson. In Bagehot was a Shadow Banker, the authors argue that dealers on financial market need a backstop from the central bank and that “central banks have the power, and the responsibility, to support these markets both in times of crisis and in normal times. That support however must be confined strictly to matters of liquidity. Matters of solvency are for other balance sheets with the capital resources to handle them.” This conclusion is mind-boggling to those who know the history of the concept “lender of last resort.” The whole point of a lender of last resort is that this is the entity that makes the determination as to whether a financial institution is solvent or not. Solvent institutions are given liquidity support and allowed to live, and insolvent institutions are not.

The term “lender of last resort” has its origins in Francis Baring’s Observationson the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.

In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain.

For this reason, it is unsurprising that Flandreau and Ugolini find that the Bank of England limited moral hazard “by not lending ‘anonymously’,” but instead by carefully tracking both its exposure to each individual acceptor and discounter, and the degree to which each acceptor and discounter was extending – or overextending – credit to others.[1] This monitoring was accompanied by the rarely-used, but ever-present, threat of refusing liquidity to the acceptor or discounter by refusing to discount its paper.[2] What Flandreau and Ugolini do not appear to realize is that similar policies were in place a full century before the time period that they study.

In 1772, the Bank of England stopped discounting the bills of the Ayr Bank (including accepted bills), because the number of bills the Ayr Bank was circulating was large enough that it was almost certain that the bills were not all “real” — that is, created only through the process of actual commercial trade. At the time a letter was published in the London Chronicle stating:

You will find that the only cause of such bills as are good at bottom being refused by private bankers in London, is because the Bank of England will not discount them, and on that account such bankers cannot turn them into cash till due, be their necessity ever so great. For this and other obvious reasons, you will find it impossible to carry on your business as a banking company independent of the Bank of England, that being the great source of the British funds, and credit without whose countenance and occasional aid, no banker, nor merchant even in London can do business with safety and profit. (Sept. 15-17, 1772)

The author of this letter makes it clear that a bank was solvent because the Bank of England stood behind it, and was insolvent if the Bank did not. In short, after the failure of the Ayr Bank contemporary bankers understood that solvency was not an exogenous state, but for each bank depended upon the on-going support of the Bank of England.

In 1802, thirty years after the Ayr Bank collapse, Henry Thornton explained that one of the fundamental roles played by the Bank of England was to limit the amount of credit available to both London banks and country banks.

While the transactions of the surrounding traders are thus subject to the view of the country banks, those of the country banks themselves come under the eye of their respective correspondents, the London bankers; and, in some measure, likewise, of the Bank of England. The Bank of England restricts, according to its discretion, the credit given to the London banker. Thus a system of checks is established, which, though certainly very imperfect, answers many important purposes, and, in particular, opposes many impediments to wild speculation. (at 176)

Thornton adds:

There seems to be a medium at which a public bank should aim in granting aid to inferior establishments, and which it must often find very difficult to be observed. The relief should neither be so prompt and liberal as to exempt those who misconduct their business from all the natural consequences of their fault, nor so scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or even ruinous may be their state. (at 188).

Thus, Thornton focuses attention on the key policy question faced by the Bank of England: When to withdraw its support from a bank or bill broker that is undermining the quality of origination practices in the market, despite the possibility that the decision could have an adverse effect on the broader market. This illustrates that the Bank of England’s decision in 1866 not to support Overend, Gurney & Co. was made in the context of a long history of similar decisions, which had as their purpose promoting the quality of the London money market.

The authors of Bagehot was a Shadow Banker view the solvency of a bank as a state that exists independent of the central bank, and they view government bailouts to protect bank solvency as a necessary corollary to lender of last resort activities “in any real world crisis.” They explain:

the maintained assumption of the present paper that the financial crisis is entirely a matter of liquidity and not at all a matter of solvency. Under this strong (and admittedly unrealistic) assumption, no additional capital resources are needed to address the crisis because there are no fundamental losses to be absorbed, only temporary price distortions to be capped. In any real world crisis, of course, there are both liquidity and solvency elements at play, so liquidity backstop is insufficient. Just so, in the US crisis, there was the Treasury standing in the wings to provide capital as needed (e.g. TARP). In this paper we have abstracted from such matters in order to draw attention to the liquidity dimension, which remains largely unappreciated. (At 14-15).

Recall, however, that, as was discussed in Part II, careful analysis of the data by economic historians demonstrates that: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.”[3] Thus, in 19th c. England the assumption that a crisis was entirely a matter of liquidity was not an unrealistic assumption at all, since the owners of the bank were personally liable for the circulation of bad debt. And, in practice, all losses were borne by the bankers.

Because the 19th British financial crises were true liquidity crises, the banks from which the Bank of England withdrew support could have continued in business certainly over the short-term and possibly for years in the absence of the denial of liquidity by the Bank of England. For this reason, in 19th c. Britain the lender of last resort’s determination that a bank was not worthy of its support was the direct cause of the bank’s failure. In short, the term “lender of last resort” refers to the central bank’s role of protecting the financial system by denying liquidity to those firms that don’t meet the standards of the central bank.

Bagehot’s prescription for the conduct of a central bank in a crisis is usually framed affirmatively: A central bank must lend freely at high rates on all good collateral. In the 19th c., however, “good” collateral was determined principally by the quality of the acceptance and of the discounter. Thus, Bagehot understood his prescription to be entirely consistent with the Bank’s rejection of paper on which one of the required guarantees was given by Overend, Gurney & Co. And Bagehot’s prescription is also entirely consistent with the disciplinary role played by the lender of last resort in denying liquidity to firms that are so badly run that they can’t give good security as a discounter on their collateral, or in other words be trusted to honor their obligations.

When one understands that the proper exercise of the power of the lender of last resort includes not only supporting the financial system through liquidity crises, but also the careful culling of financial firms to protect the monetary system from badly run firms and the circulation of poor quality assets in the money supply, one realizes that more attention should be paid in the modern literature to the dangers of using liquidity support to keep poorly run firms alive. Instead of assuming, as the authors of Bagehot was a Shadow Banker do, that liquidity crises are always accompanied by solvency crises that must be addressed by government bailouts, it is important to realize that the pre-eminent model of a lender of last resort developed in an environment where there were no bailouts.

Therefore, it seems likely that need for bailouts that is common to so many recent crises may reflect the failure on the part of the central banks to protect the money supply by refusing liquidity support to those firms which are so poorly managed that they are introducing bad assets into the money supply. Indeed, Bagehot warned explicitly that government support of a “bad bank” can have extremely adverse effects on the financial system, because such support “is the surest mode of preventing the establishment of a future good bank.”[4]

This analysis of the term “lender of last resort” allows us to reevaluate the authors’ call for the central bank to act as a “dealer of last resort,” whose job is to put a floor on the price not only of prime securities, but also of non-prime securities by accepting the latter as collateral. But just as the lender of last resort has the duty of determining which banks are well enough managed to merit liquidity support, so the dealer of last resort would have the duty of determining which assets are of a quality that merits price support. Note that this is a determination of asset quality, and thus broad categories of acceptable assets cannot substitute for a review of the bank-specific origination and servicing practices that will determine the true quality of the asset. In short, asking the central bank to act as a “dealer of last resort” is asking it – in the midst of a crisis – to review the underwriting of the loans created by the banking system.

One way to avoid this problem is for the central bank to limit the class of assets on which it lends to those assets that are of high quality, and thus easy to price. But that, of course, is precisely what a traditional lender of last resort does – and it is precisely this protection that the proposed “dealer of last resort” seeks to eliminate. Another way to avoid this problem is to monitor the banks themselves and require that they provide a guarantee of the value of any assets that are aggregated by the bank to be used as collateral for a loan from the central bank. Once again, however, this is a very traditional means by which lenders of last resort have long expanded their lending quickly to the most trusted banks in crises.[5] Perhaps the authors in their proposal for a dealer of last resort seek to expand this ability for banks to package and value their own collateral so that it is more generally available. If so, the problem of moral hazard that is created by this system needs to be addressed, since one would expect the weakest banks to use such a lending facility to gamble for redemption.

My reading of the authors’ proposal for a dealer of last resort, however, is that the authors assume that the central bank has the ability to determine on an asset-by-asset basis the appropriate level for price support. Thus, the authors seem to believe that the central bank will be able to intuit the correct level of price support for the non-prime assets of the banking system without re-underwriting the loans to distinguish which are likely to be performing in the future and which are not. It would be helpful if the authors explained the mechanism by which the central bank is to perform the pricing aspect of its role as dealer of last resort.

This is Part II of a lengthy critique of the paper, Bagehot was a Shadow Banker. First, this Part explains a few of the means by which modern banks address the funding risk inherent in the shadow banking system by providing services that are very similar to acceptances. Then, the maturity of the assets funded on 19th c. and modern markets is discussed along with the consequences of the fact that capital assets are financed on modern markets, creating market risk, in addition to funding risk. Finally, the likelihood that the credit quality of 19th c. money market assets was significantly greater than that of modern assets is explored.

A. Modern equivalents of 19th c. acceptances are common in the modern shadow banking system

The paper correctly explains that an “acceptance,” or the guarantee of payment by a London firm whose acceptance made the bill eligible for discount at the Bank or England, was what made a bill liquid or tradable on London money markets. (Note, however, that it was not unusual for bills to circulate locally without a London acceptance.[1]) The paper makes the rather odd claim, however, that “the closest thing we have to the institution of ‘acceptance’ is the credit default swap” (at 6). On the contrary, the modern shadow banking system is replete with a wide variety of bank guarantees that make otherwise illiquid assets liquid.

The commercial paper market, a cornerstone of the shadow banking system, has always relied on “backup lines of credit” or “liquidity facilities” provided by banks to make it possible for non-financial issuers – and asset-backed commercial paper conduits – to market their commercial paper. These facilities mean that, even if a firm (or conduit) is facing liquidity difficulties when the commercial paper matures, the bank guarantees that the commercial paper will be retired at maturity.[2] In theory, these facilities were designed to address only liquidity problems and did not enhance the credit quality of commercial paper issues; however, regulatory capital requirements made the provision of credit facilities much more costly for banks than the provision of liquidity facilities and, as a result, liquidity facilities were structured to provide credit enhancement along with a liquidity backstop.[3] Just as an acceptance made 19th c. bills marketable in London, so the backup facilities provided by banks to commercial paper conduits make commercial paper marketable in modern markets.[4]

The other cornerstone of the shadow banking system is the repurchase agreement, or repo, market. The most important repo market is the tri-party repo market and this too is anchored by bank guarantees of liquidity. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day (to give the borrowers access to their assets during the day), the two tri-party clearing banks, J.P. Morgan Chase and Bank of New York Mellon, extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[5] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[6] Here, we find that the liquidity of a key shadow banking market is created by bank guarantees, similar to the reliance of the 19th c. London money market on acceptances.

In short, both the commercial paper and repo markets derive their liquidity from bank guarantees. These guarantees seem to be the closest analogs to the acceptances issued by 19th c. London banks. Let us evaluate, however, the claim that a credit default swap is also an analog of an acceptance.

The most important difference between a credit default swap (CDS) and an acceptance is that combining a CDS on mortgage backed securities with mortgage backed securities, for example manufacturing a collateralized debt obligation or CDO, does not produce a liquid asset. (This is true of the backup facilities provided to commercial paper issuers too.) The additional protection may have made the aggregate product marketable, in the sense that the product could be placed once with an investor, but it did not make it liquid in the sense that it created an asset that was traded actively on a market or circulated from hand to hand as a form currency.

Another important difference is basis risk. Unlike acceptances and the guarantees provided to commercial paper issues or to tri-party repo unwinds, a CDS is not related to a particular debt obligation. As the authors of Bagehot was a Shadow Banker note, because a CDS does not guarantee payment of a particular debt, the payment received on a CDS will not necessarily be sufficient to compensate for the amount lost on the unpaid debt. This is basis risk: the risk that the hedging instrument is not a good match for the hedged instrument.

As I understand it, however, when comparing a CDS to an acceptance the authors’ principle claim is that an acceptance converted a non-prime asset, the bill, to a prime asset, the accepted bill, just as a CDS (together with an interest rate swap (IRS) and foreign exchange swap, if needed) converts a risky long-term asset into a “risk-free” prime bill or short-term asset. Thus, the point is that both an acceptance and a CDS (plus IRS) can be used to convert non-prime assets into prime short-term assets. (In my view, bank backup facilities provided to commercial paper and repo markets can play the same role as acceptances in converting non-prime credit risks into prime credit risks, but that was addressed above.)

The nature of the non-prime, risky assets being funded on the money markets in the 19th c. and in modern markets differs in two important respects. First, the risky non-prime assets in modern markets are long-term assets, and as such carry very different risks than the short-term assets funded in the 19th c. Second, the credit quality of the non-prime assets in the two markets is not necessarily comparable.

B. Maturity of assets funded on the money market

The authors of Bagehot was a Shadow Banker define shadow banking as “money market funding of capital market lending” and describe it as “the centrally important channel of credit for our times” (at 2). Capital market lending generally refers to lending with a maturity in excess of one year, and contrasts with lending on money markets for terms of one year or less. (They also describe shadow banking at great length as a “market based credit system.” The question of whether a market based credit system has ever existed will be discussed in Part IV.) The authors do not attempt to show that money market funding of capital market lending took place on a significant scale in Bagehot’s time.

Instead the authors claim that the bill brokers of Bagehot’s day were comparable to money market dealers of the modern era, acknowledging that the market at issue in the 19th c. was a market in short-term private debt (at 4-5). In one sense, I agree with the authors: as argued in Part I, bill brokers were the shadow banks of mid-19th c. England. But it is important to note that the bill brokers’ activities do not meet the authors’ definition of shadow banking, because the funding of capital market lending was a not a legitimate focus of their activities.[7] The business of the bill brokers and of the bankers was the funding of money market instruments that were issued by businesses throughout Britain and functioned as a form of working capital. These money market instruments were short-term and did not involve lending on capital markets.

In contrast, the fact that long-term assets are funded short term by the modern shadow banking system means that modern shadow banking is not “a bill funding market, not so different from Bagehot’s,” but a capital asset funding market. It is for this reason that “mere guarantee of eventual par payment at maturity doesn’t do much good” since “so many promised payments lie in the distant future” and the only option for a lender in a liquidity crisis is to sell the asset or use it as collateral to borrow. Thus, the need for market liquidity is generated by the fact that long-term assets are being funded.

Although the authors imply that market liquidity and funding liquidity – or guarantees of payment in the event of default such as acceptances, backup credit lines, and tri-party clearing bank guarantees – are substitutes (at 7), in fact, modern markets require market liquidity in addition to funding liquidity. In short, the reason that modern markets require a different form of support from 19th c. markets is that by funding long term assets they have characteristics that mean that they are very different from – and much less safe than – 19th c. markets.

Funding long-term assets with short-term liabilities creates funding risk, that is, the risk that you can’t pay the maturing paper by rolling it over into new short-term debt, and relies on bank guarantees in the form of liquidity facilities or tri-party clearing bank guarantees to address this risk. Funding long-term assets with short-term liabilities also creates market risk, the danger that the value of the assets drops significantly below the value of the short-term liabilities before they are refinanced. CDS and IRS are designed to address market risk, but cannot address funding risk. The latter is addressed by the liquidity guarantees provided by banks that are common in the shadow banking system.

Where there is market risk, that risk can be exacerbated when a borrower whose assets have fallen in value is forced to sell assets to get the cash to make up the difference between the value of the collateral and the debt. The sale of assets can drive the price of the assets down further worsening the borrower’s position and forcing additional sales. This has been termed a “liquidity spiral” (though I prefer Richard Bookstaber’s phrase “riding the leverage cycle to hell”).

The authors argue that in order to prevent such liquidity spirals the central bank should act as a “dealer of last resort.” This role requires two changes to the traditional lender of last resort role: first, the central bank should purchase prime securities outright, and, second, it should accept as collateral non-prime securities in order “to put a floor on their price in times of crisis” (at 9). While it is trivially true that an omniscient central bank which knows the “true” value of the assets and the swaps could indeed put a floor on prices in times of crisis, the real question is whether a less-informed real-world central bank can effectively play the role of dealer of last resort.

C. The credit quality of 19th c. assets as compared to modern assets

Another important characteristic almost certainly differentiates 19th c. money market assets from those of modern markets: the personal liability of the issuers and the guarantors. The authors of Bagehot was a Shadow Banker note that “sloppy, or even fraudulent, underwriting” contributed to the severity of the 2008 crisis (at 13 n.3). By contrast in 19th c. Britain, issuers and bankers faced unlimited liability – or capital calls if they were stockholders – on their obligations. Because of the personal stake that the bankers and the owners of banks had in the success of their business, the general credit quality of both assets and acceptances in 19th c. Britain was almost certainly higher than that of the underlying assets or CDS of modern markets. After careful analysis of the data economic historians have concluded: “The Bank of England operated in an almost perfectly risk-free market, whereby losses were entirely transferred to market participants.”[8]

Thus, another important distinction between a CDS and an acceptance is the fact that a CDS is issued by a modern corporation whereas an acceptance was issued by either an unincorporated firm or a 19th c. British joint stock firm. A debt incurred in the normal course of business by a modern corporation cannot result in a personal claim against a banker or bank shareholder even in bankruptcy. By contrast, an unpaid debt incurred by a 19th c. British joint stock bank was likely in bankruptcy to result in a capital call on the bank’s shareholders. Because joint stock investors in 19th c. Britain typically paid only a fraction of the par value of the shares, the corporation – or in the case of bankruptcy the liquidator – retained the right to call the remaining value of the shares until par was fully paid up. Thus, when Overend failed in 1866, the joint shareholders were required to pay to the liquidators 50% of par, more than their initial investment of 30%, and, as a result, the creditors were finally paid in full.[9] Of course, for unincorporated banks, all bankers were personally liable for the debts of the bank.

Needless to say, in 19th c. Britain one of the reasons for confidence in the guarantees provided by the banking system was the visible personal wealth of the bankers themselves and the knowledge that this wealth was at stake.[10]

Not only were the bank guarantees in 19th c. Britain of higher credit quality than those issued by modern corporations, but the underlying assets were most likely of higher credit quality too. While mortgages and other forms of consumer credit – often originated using faulty procedures – are an important raw material for modern shadow banking, in 19th c. Britain the credit issued was strictly commercial, and it was only put into general circulation when a local bank or London middleman guaranteed the debt through endorsement or acceptance, usually on the basis of personal knowledge of the issuer. As a result of this system, backed by multiple personal guarantees, the assets circulating in 19th c. British money markets were of extremely high credit quality.

Bagehot, when describing the optimal lender of last resort policy of discounting all good securities, describes the 19th c. credit environment: “No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the ‘unsound’ people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected.” In fact, because of Overend’s “bad business,” Bagehot clearly approved of the Bank of England’s decision not to support the bill broker, despite the fact that its failure caused a massive liquidity crisis. (Lombard Street VII.37, VIII.12, X.10-11).

Overall Bagehot was a Shadow Banker fails to recognize that funding risk is as important to modern markets as market risk. For this reason, bank guarantees of payment, the equivalent of acceptances, are relied on in the modern shadow banking system, just as they were in the 19th c. Modern money markets also face market risk because they finance capital, not just money market, assets. It is market risk that the “dealer of last resort” purports to address, by placing the burden on the central bank of determining the correct price floor for non-prime assets. This determination is likely to be complicated by the fact that flaws in modern origination processes together with a paucity of personal guarantees make it possible for low quality assets to end up backing the money supply.

[4] In addition to liquidity and credit facilities, letters of credit have long played a role in commercial paper markets. The standby letter of credit is a guarantee made by a bank to retire maturing debt if the issuer cannot. It has been used for decades to enable firms, whose stand-alone credit rating is not high enough for them to issue commercial paper, to “rent” the credit rating of the bank. Thomas Hahn, Commercial Paper, 79 Fed. Res. Bank of Richmond Econ. Quarterly 45, 58 (Spring 1993). In addition, the letter of credit is a traditional banking instrument, still in use today, that promises to honor any bill drawn in conformance with the letter of credit. Typically goods have been shipped to the party whose debt is guaranteed by the bank, and the shipper will be paid as long as evidence of the shipment and of the debt are appropriately documented. The letter of credit remains an important means of financing international trade.

[6] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[7] Indeed, Overend, Gurney and Co. failed in part because, instead of recognizing losses on bad bills, it converted them (due to inadequate management and less-than-honest employees) into long-term investments in, for example, steamships that ended up causing the losses that took the firm down, despite its robust bill-broking business. W.T.C. King, History of the London Discount Market 247-51 (1972).

This is Part I of a lengthy critique of the paper, Bagehot was a Shadow Banker. In this section I explain first the nature of the 19th c. monetary system in Britain, then discuss the way that the system was understood and explained by contemporary theorists, and wind up by detailing some of the factual errors in the paper.

A. Money in the 18th-19th c.

1. Constraints on finance prior to the 19th century

As the middle ages were coming to a close Europe developed a financial instrument called the bill of exchange that was managed by a network of wealthy merchant bankers. In its initial form the bill of exchange was used to finance international trade between Europe’s leading cities. The bill was a short-term debt contract that was payable in a foreign country. Clearing mechanisms enabled trade in these bills to minimize the transport of gold and silver across Europe.

In the sixteenth century the bill of exchange evolved into a very different instrument. Endorsement allowed bills to circulate from hand to hand before being redeemed, and domestic bills became the norm in highly developed commercial economies. Local bankers managed local networks and stood ready to discount bills before they were due. Thus, a tradesman with a local bank account could write a bill in the name of a supplier, who could then choose to hold the bill, endorse the bill over to a creditor of his own or cash it – less a discount – at the bank. The bill was a form of commercial paper that was endorsable and effectively allowed banks to underwrite a system of trade credit for the local community. The result was that trade in urban economies began to take place on the basis of a paper monetary system that was supported by a network of banks.

In order for the system to work, standards had to be put into place to prevent the local tradesmen from writing too many bills. In practice a single principle was used to regulate this credit system: A bill was valid only if it was issued in exchange for goods. Bills that were written in the absence of a real exchange were described as “fictitious” or “accommodation paper.” Any tradesman who was caught issuing fictitious bills was considered a fraud and excluded from the financial network. Suspicion of such fraud could also derail a tradesman’s career.

The principle that bills were valid only when they were issued in exchange for real goods is now known as the Real Bills Doctrine. This doctrine was the standard our early modern ancestors put in place to ensure that finance served the needs of trade. It had the advantage of being applied at the individual level, creating a completely decentralized means by which the issue of financial paper could be controlled.

Nowadays the real bills doctrine is famous because it played an important part in the debate over monetary policy that took place in England in the early 19th century, and is associated with Adam Smith. The Currency School argued that the Bank of England should be constrained to issue bank notes in an amount that did not exceed the amount of gold it held in its vaults, while the Banking School argued that the real bills doctrine was sufficient to control the money supply and that the Bank needed to have the flexibility to issue an indeterminate quantity of bank notes when discounting real bills. It’s worth noting that the real bills doctrine was so fundamental to the 18th and early 19th century concept of financial stability, that no one questioned the necessity of adhering to the doctrine. The issue in the debate was whether or not the real bills doctrine alone was sufficient to ensure financial stability.

The denouement of this controversy took place when the Bank Charter Act of 1844 was passed. This was effectively a compromise. Only the Bank of England was allowed to issue bank notes and the Bank’s issue was fixed by the amount of gold in its vaults; however, the Act was subject to suspension by executive order. In practice, this meant that the Bank of England’s note issue was restricted – unless economic circumstances required a greater supply of notes. The Act was temporarily suspended in 1847, 1857 and 1866.

2. The 19th century evolution of the financial system

In the meanwhile, the British economy was steadily outgrowing the real bills doctrine itself. By the start of the 19th century in England the system of domestic bills had evolved into acceptance finance. A country tradesman who regularly shipped his wares to a London middleman for sale would draw on his account with the middleman when making purchases in his own local community. The tradesman would write a bill drawn on the London middleman to pay his local supplier. The supplier would go ahead and circulate the bill through endorsement. However, until the bill was discounted at the local bank, sent by the banker off to his London correspondent for settlement and formally accepted by the London middleman as an obligation, there was no certainty under the law that the middleman would pay.[1]

In short, acceptance finance was a prototype for the checking account system that would develop decades later – just like a checking account system it required that (i) bad bills or checks be passed infrequently and (ii) middlemen or bankers could be relied on to honor their obligations. When one recognizes the sophistication of the financial system in Britain at the turn of the 19th century, one begins to understand why Henry Thornton considered the “science” of credit to be the fundamental source of British growth at the time.[2]

Now here is the question: Is the bill drawn by the country tradesman on the London middleman a real bill or a fictitious bill? Assuming they have an ongoing relationship is there anything wrong with a middleman accepting the bill before he has received a delivery of goods? Is there anything wrong with a middleman extending an overdraft to a tradesman? It was probably inevitable that the practice of acceptance finance broke down the cultural barriers that had supported the real bills doctrine. Henry Thornton’s Paper Credit makes it clear that by the early years of the 19th century, some British bankers were beginning to realize that a “good bill” could be backed by nothing more than an individual’s personal credit.

Legal cases demonstrate that the use of accommodation paper was growing – and becoming more acceptable – through the first decades of the 19th century.[3] The Banking Act of 1844 started a different trend: banks that were no longer allowed to issue bank notes found another way to create money, the checking account. These two trends combined to create a new financial system centered around banks as the arbiters of credit.

The 19th century witnessed a transition from a decentralized system of paper money that was controlled by adherence to the real bills doctrine to a more complex system in which short-term monetized credit was allocated by banks. A new approach had to be found to control the growth of the new monetary system based on checking accounts. The Banking Act of 1844 had been a first effort at direct control of the money supply. It was unsuccessful in many ways: In the first quarter century after it was passed, it had to be suspended three times in order to protect the economy from the ravages of liquidity crises. And the growth of checking accounts effectively neutered the Act.

In the meanwhile, however, the Bank of England had a discovered a new tool for controlling the money supply. In the 18th century the Bank’s discount rate had remained fixed at 5%. As a consequence in normal times competing banks took most of the trade, and the Bank’s discount business was relatively small. In a liquidity crisis, however, the Bank’s discounts would increase astronomically for a few days or even weeks only to fall back to normal when the panic had eased.

In the first half of the 19th century a major concern of the Bank was the maintenance of its gold reserves. Thus, the outflow of gold that was associated with crises and strong demand for discounts at the Bank caused concern. It didn’t take long for the Directors of the Bank to realize that by raising the discount rate, they could moderate the outflow of gold.[4] In the 1820s Bank Rate, or the discount rate of the Bank of England, started to be used as a policy tool. By the middle of the century Bank Rate was the principal policy tool that the Bank used to control the flows of gold to and from the Bank and to moderate the growth of credit and of the money supply.

3. The genesis of fiat money

England developed a paper monetary system in the late 18th century. The monetary system was not uniform across the country. In commercial regions a large fraction of the circulating currency took the form of domestic bills. Local bank notes were often an important part of the currency too, especially in agricultural districts. Bank of England notes were issued in large denominations and were important for settling interbank accounts, but circulated very little in the countryside.

This state of affairs changed dramatically in 1797. The finance of the Napoleonic Wars had put an enormous strain on the financial system and the Bank of England risked running out of gold. The solution was the suspension of the convertibility into gold of the Bank of England note. This suspension lasted for almost a quarter of a century.

As the local banking networks had relied through their London correspondents on the gold reserves of the Bank England in order to meet the demands of their own customers, it was no longer possible for local banks to pay out their notes in gold upon request. To resolve the settlement problem in the countryside, the Bank of England began to issue notes in small denominations – making it possible for the local banks to pay out Bank of England notes instead of gold.

Thus, at the turn of the century the British economy shifted very smoothly from a gold standard to a fiat money standard. During the war the economy experienced a moderate level of inflation with the result that when the war finally ended in 1815 it was not immediately possible to resume convertibility of the Bank of England note into gold at the rate that prevailed in 1797. Policymakers, however, were committed to resumption at the original exchange rate. Thus, in the years following the Napoleonic Wars the British economy was put through a severe recession and in 1821 convertibility of the Bank of England note was restored.

Despite the fact that gold was now readily available, country banks continued to settle their obligations in Bank of England notes with frequency for the simple reason that Bank notes were accepted by almost everyone. Bank of England notes displaced gold as a means of settling trades, because they were in practice “good as gold”.

Thus, the foundations of a modern banking system were laid in 19th century Britain. Paper bank notes were universally accepted in final settlement of debt. The banking system offered checking accounts to the general public and short-term credit to those that met the criteria of the bankers. And finally the whole system was moderated by the Bank of England’s control over the short term interest rate on bills discounted at the Bank. The great 20th century innovation would be the shift to a true fiat money standard with no convertibility of bank notes into any kind of real asset.

B. Early Monetary Theorists’ View of the Relationship Between Banking and Growth

Almost a century before Bagehot, Adam Smith and Henry Thornton discussed the role played by the banking system in the economic growth of Britain. Chapter 2 of Book II of the Wealth of Nations is devoted to explaining how banks contribute to the recent increase in trade and industry of Britain. In addition, Smith remarks on the importance of the Bank of England and the role it played in “support[ing] the credit” of the largest banks in England, Germany, and Holland, including an anecdote about how in 1763 the Bank advanced in a single week £1.6 million (equal at the time to almost a quarter of the Bank’s total liabilities) “a great part of it in bullion” (at II.2.85). For Smith, the mechanism by which banking contributed to growth was by expanding the metallic money supply and conserving on the circulation of gold and silver. In short, it was because bank money was not collateralized by “safe assets” like gold or silver that it could play the role that it did in increasing the money supply.

As noted above, Henry Thornton was one of the early proponents of the acceptance finance system that developed in the first decades of the 19th century, and of the concept that bankers’ lending should be tied to the individual credit of the borrower rather than to specific transactions (Paper Credit at 89). Thornton, too, emphasized the importance of the expansion of the money supply that the use of bills entailed. He criticized Smith for failing to recognize that bills didn’t just expand the metallic money supply, but also the supply of bank notes, and emphasized that bills improved the money supply, because they were an interest bearing form of money. As a result, Thornton found that bills were a preferred form of money for those engaged in commerce (at 92).

Thornton, too, had a fine understanding of the role of a lender of last resort in a crisis: “That a state of distrust causes a slowness in the circulation of guineas, and that at such a time a greater quantity of money will be wanted in order to effect only the same money payments, is a position which scarcely needs to be proved” (at 99). He continues to establish the difference between a central bank, which “is completely subjected to the interests [of the public]” and a “private house” which “may be in general considered as having in the bank [of England] a sure resource” (at 126 -27). Thornton defends the 1797 suspension by the Bank of England of payments in gold and argues that, if the Bank of England erred in this time period, it erred “on the side of too much restricting its notes in the late seasons of alarm” (at 127). Thornton makes it abundantly clear that a central bank which can expand the money supply is needed to support the banking system through a liquidity crisis.

Finally, Thornton attributes “the flourishing state of our internal commerce” to the role played by the banking system in providing a credit-based monetary system (at 175-76). He also explains very clearly that transactions based on credit are essential to the operation of the British economy (at 100-02).

In short, both Adam Smith and Henry Thornton understood the importance of banking to the economic growth that they were witnessing in Britain on the eve of the 19th century. They also understood the role that the Bank of England played during crises in supporting that growth and in supporting the existence of a credit-based economy. Thus, it is literally painful to read statements in Bagehot was a Shadow Banker such as “At the time, that Bagehot was writing, this backstop function [of the central bank] was not yet fully understood, much less accepted” or “the central banks of Bagehot’s time . . . employed their balance sheets to stem the downturn . . . [but] did so without much prior theory about why it would work, and with hardly any thought about possible implications for more normal times” (both at 1).

The authors’ source for the first claim is Forrest Capie, but I believe they misread him (and no source is given for the second claim). Capie writes that the lender of last resort role was addressed “comprehensively” by Thornton in 1802 and that Bagehot wrote about it in the 1840s. In the context of this theory of a lender of last resort, well-developed more than a quarter century before the publication of Lombard Street,Capie writes: “But the Bank of England learned its role as lender of last resort slowly. It resisted for a long time the advocacy of theorists.”[5] The continuation of Capie’s discussion indicates that the Bank had fully mastered the lender of last resort role by 1866. In 1866 the Bank allowed Overend Gurney & Co. to fail – in an event similar to Lehman’s failure, but without requiring any subsequent bailouts – and this was according to Capie the apparent apogee of the Bank of England’s learning process, resulting in “over 100 years of financial stability” (at 16). Lombard Street was published in 1873, six year later. Bagehot agreed that Overend’s failure caused “a crisis for which the Bank of England can[not] be blamed” (Lombard Street at VII.37).

Not only was the theory of the lender of last resort well developed by the mid-1800s, but the problems in normal times of moral hazard created by the actions of the lender of last resort were well understood. A model of moral hazard is the best explain for the contradictory stance of the Bank of England described by Bagehot, who found that by the 1850s the lender of last resort role was both understood and performed by the Bank, while at the same time the role was unacknowledged and sometimes even denied by the Bank (at VII.33). Further evidence of a conscious effort to manage the moral hazard of the lender of last resort’s role is that the Bank of England carefully laid the groundwork for the failure of Overend in 1858, eight years before the Bank refused to save it.[6] In fact, Overend was a bill-broker, which like modern shadow banks was a type of money market lender that held less capital than traditional banks and therefore put extreme stress on the central bank in times of crisis (Lombard Street at XI.21 ff). Because the bill-brokers had borrowed more than the banks in the 1857 crisis, in 1858 the Bank of England, put in place a policy of not standing ready to support the shadow banks in a crisis, but of lending on a “special” basis only. Thus, according to both Bagehot and Capie, the great success of the Bank of England as a lender of last resort was the decision to let the largest of the shadow banks fail – and it was this decision that led to “over 100 years of financial stability.”[7]

The authors of Bagehot was a Shadow Banker may be correct that the central bankers of our own time acted during the crisis without any theory of why their actions would work and “with hardly thought about possible implications for more normal times,” but they are not correct that the Bank of England acted in the 19th c. without a theoretic framework or concern for the moral hazard created by the Bank’s actions.

C. Additional Errors of Fact in Bagehot was a Shadow Banker

“Reading Bagehot, we enter a world where securities issued by sovereign states are not yet the focal point of trading and prices …” (at 4). On the contrary, at the very heart of the 19th c. English money market lay “government stock,” that is, a government bond called a consol that paid 3% per annum, and Exchequer (i.e. Treasury) bills. 19th century manuals on the business of banking explain “the proper investment of the surplus funds of the bank,” and the relative merits of consols, Exchequer bills, and commercial bills.[8] Such texts make clear that the analysis of liquidity, interest rate, and credit risk was well understood in 19th c. money markets. (The advice is, however, extraordinarily conservative by today’s standards.) Furthermore, in a seminal article written a quarter century ago, Douglas North and Barry Weingast argued that the development of a stable market for public debt likely contributed significantly to the market for private debt that the authors of Bagehot was a Shadow Banker are discussing.[9]

The authors model of the 19th c. banking system in Figure 2 appears to indicate that when non-financial firms had a surplus and wished to lend money on the money market, they held accounts at the Bank of England. In fact, the deposits at the Bank of England were composed largely of government deposits and bankers’ deposits – i.e. bank reserves (Lombard Street XII.5 ff). The Bank of England’s role was, instead, to backstop a circular system of lending between firms. That is, most firms had significant liabilities to their suppliers, while simultaneously holding as assets the liabilities of the purchasers of their products. Thus, a decentralized system of credit was supported by local banks which stood ready to discount and provide cash against these short-term business debts on an as needed basis. When a local bank needed cash it could, in turn, discount the bill with a London banking house or bill broker. For the larger local banks their signature on the bill qualified as an acceptance at the Bank of England, so the London discounter could use the bill to draw cash from the Bank of England. In normal times, the need for cash was not severe and the local firm was likely to just hold on to the interest-bearing liabilities of his purchasers. Of course, the willingness of the local firm to hold the purchaser’s debt was predicated on its liquidity and the ability to cash it out on a moment’s notice. In addition, to the degree that there were asset-rich firms — particularly in agricultural regions — they often held their deposits in local banks which gave them access to money-market returns via London correspondent bankers who could lend the funds out on the government debt and public and private bill markets. The Bank of England was an essential backstop to the English banking system, but it was not a key intermediary in the system as Figure 2 implies.

Note that Figure 2 also errs in indicating that bills discounted at the Bank of England were accompanied only by the guarantee of the acceptor. In fact, the discounter also guaranteed payment on the bill. Thus, every bill held by the Bank was supported by the credit of at least three parties, the issuer, the acceptor, and the discounter. Each of these parties was liable for the full value of the bill.

The authors describe the private bill market of Bagehot’s time as “a market in short-term private debt, typically collateralized by tradable goods.” (at 5) The private bills that circulated in Bagehot’s era were not collateralized. Thornton explained the situation clearly: “it may be observed, first, that the notes given in consequence of a real sale of goods cannot be considered as, on that account, certainly representing any actual property. Suppose that A sells one hundred pounds worth of goods to B at six months credit, and takes a bill at six months for it; and that B, within a month after sells the same goods, at a like credit, to C, taking a like bill; and again that C, after another month, sells them to D, taking a like bill, and so on. There may then, at the end of six months, be six bills of £100 each existing at the same time; and every one of these may possibly have been discounted. Of all these bills, then, one only represents any actual property.” (at 86). Bagehot’s discussion in Chapter II of Lombard Street makes it clear that he too is discussing the same type of bill, because there is no discussion of collateral or the possibility that a creditor forecloses on collateral.[10]

The uncollateralized nature of the British money supply in the 19th c. is unsurprising given that both Adam Smith and Henry Thornton were convinced that the banking system promoted growth by making it easy for the money supply to expand. Under this theory, as Thornton clearly understood, limiting the expansion of the money supply to the supply of collateral would have functioned as a constraint on economic growth itself. In short, the whole point of the 19th c. system of private bills in Britain is that they were not collateralized, instead they were typically generated as part of the process of trade (that is, even under the acceptance credit system, goods were regularly transferred, there was just no requirement that every bill be created in the process of such a transfer).

[7] Flandreau and Ugolini argue that the fact that the Bank lent freely to the remaining bill-brokers after allowing by far the largest of them to fail is evidence that the 1858 policy was simply rhetoric. Flandreau and Ugolini, at 14. However, if one views the Bank’s purpose as being one of saving the money market, not destroying it, then one can easily conclude that by allowing Overend to fail, the Bank’s goal was achieved and the subsequent aid to other bill-brokers was entirely consistent with that goal.

[8] See, e.g. James William Gilbert, The Logic of Banking 196-98 (1856).

A paper titled Bagehot was a Shadow Banker came to my attention last month. While I know that the authors, Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson are very smart and am confident that they are also well-intentioned, none of them has engaged in the careful study of British monetary history that would allow them to support the claim made in the title of their paper. As a result, their conclusions are built on a flawed understanding of the nature of both 19th century and, I would argue, modern finance.

The authors of Bagehot was a Shadow Banker argue that the shadow banking system, in which long-term assets are funded using short-term commercial paper and repurchase agreements, should be stabilized by price supports provided by the central bank to the long-term assets. This role for the central bank is dubbed the “dealer of last resort.” Their point is that this role is a natural extension of the “lender of last resort” role of the Bank of England that Bagehot famously described. In the 19th c. the Bank of England purchased on a recourse basis (i.e. discounted) only short-term assets. Typical assets matured within three months, though it is not unlikely that longer paper of one or even two years may have been discounted in the later years of the century. For very select accounts, the Bank also advanced funds on a temporary basis (similar to a modern repurchase agreement) against long-term government bonds and borrower-selected “parcels” of short-term assets.[1]

My goal in this paper is to demonstrate that Bagehot was a Shadow Banker (i) misunderstands the nature of the 19th century English monetary system and the means by which it supported the economic growth of England at the time; (ii) ignores crucial characteristics of the 19th century monetary system, such as the personal liability faced by bankers – or the capital calls faced by bank shareholders – when banks circulated assets that went bad; and (iii) fails to understand that the term “lender of last resort” is a direct reference to the fact that bank solvency is endogenous and actively determined by the central bank, not an exogenous characteristic of an individual bank. Because the paper is built on the pretense that the illiquidity-insolvency distinction is a property of individual banks, rather than a determination made by the central bank, the paper conceals the fact that any “dealer of last resort” will have the task of making the final determination of the “true” value of the assets.

The movement from a lender of last resort to a dealer of last resort is, therefore, a significant change, because by purchasing “prime” assets at a specific price the dealer of last resort removes from the selling bank the obligation of guaranteeing the value of the assets. Instead of indirectly supporting the prices of assets (which indeed has always been a role of the lender of last resort), the dealer of last resort directly supports asset prices and eliminates the measure of market pricing of assets that has always existed under lender of last resort systems. A bank that knows an asset is bad and sells it at an inflated value to a lender of last resort will have to come up with the difference in value in the future or the bank will fail. This is a strong disincentive to passing bad assets, particularly in 19th c. financial systems where bankers’ personal assets’ were on the line. It is precisely this disincentive to passing bad assets off on the central bank that the authors apparently wish to eliminate by establishing a dealer of last resort – and that they claim is a policy that Bagehot would have supported.

The distinctions between the 19th c. environment and the modern environment are very important, and are neither addressed – nor indeed even acknowledged – by Bagehot was a Shadow Banker. The Bank of England determined which assets were worthy of being discounted in an environment where almost no bad assets circulated: the assets eligible for discount were of high quality, not only because they had very short maturities and thus limited exposure to unexpected events, but also because the bankers who circulated the assets put their personal wealth at risk by accepting them and then discounting them.

Thus, the claim that “Bagehot would have recognized [the dealer of last resort] as a fully legitimate support of the prime bill market” is overstated. Bagehot would not have recognized the finance of assets of more than a few years maturity as the business of any banker, much less the business of a central banker. Bagehot would have been horrified at the “sloppy, or even fraudulent, underwriting” that led to the 2007-08 crisis, (at 13) and might well have recommended that the government disentangle itself from such a monetary system entirely.[2]

I will address first the nature of the 19th c. monetary system and the means by which it supported economic growth in the understanding of 19th c. theorists. Next I will address the quality of the assets that circulated as money in the 19th c. and the importance of the personal liability of bankers to the quality of the assets. Third, I will address the origins of the term “lender of last resort” and the emphasis the term places on the endogeneity of the concept of solvency. Finally, I will discuss whether the claim that a “market-based credit system” exists in modern markets is well-founded.

[1] Marc Flandreau and Stefano Ugolini, Where it all began: lending of last resort and the Bank of England during the Overend-Gurney panic of 1866, Norges Bank Working Paper 2011-3 at 7, 31 (2011).

[2] “So long as the security of the Money Market is not entirely to be relied on, the Government of a country had much better leave it to itself and keep its own money. If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.” Lombard Street, IV.4.